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Taxable municipal credit recovery gains steam
- Returns were negative for high-grade taxable municipals, but BBB-rated bonds demonstrated positive returns as spreads narrowed.
- Federal stimulus could substantially boost credit and help accelerate spread narrowing.
- An infrastructure bill may provide additional catalysts to support the U.S. municipal market.
Like many fixed income investments, taxable municipal bonds lost ground in the first quarter amid rate volatility sparked largely by upward revisions to U.S. growth expectations. However, municipal bonds, both taxable and tax-exempt, generally fared better than many other areas of the bond market. Credit conditions continued to improve, supported by economic reopening and U.S. government stimulus. Demand remains strong, especially with higher yields, a more constructive credit outlook and low hedging costs.
Municipal market backdrop: good news is boosting treasury yields
U.S. Treasury rates have been rising, but for positive reasons. First-quarter GDP data is expected to show an economy expanding at an 8% to 10% annualized rate. COVID-19 vaccine rates are accelerating and daily reported cases of the disease have fallen sharply. Warmer weather will help with reopening.
The 10-year Treasury bond yield nearly doubled in the first quarter of 2021, increasing by 82 basis points (bps) from 0.92% to 1.74%. Similarly, the 30-year Treasury yield increased by 76 bps from 1.65% to 2.41%. Most of the increase has been in 10-year maturities and beyond, as the U.S. Federal Reserve’s policy and near-term outlook have locked down the short end of the yield curve, causing it to steepen.
The future trajectory of inflation has become a hot topic across fixed income markets. Through February 2021, the annualized rate of increase in core inflation actually declined to 1.4%. However, most investors believe this level is temporarily depressed due to the pandemic. Anecdotes and purchasing managers’ surveys suggest that inflation is poised to pop as the economy moves to full reopening.
Prices of certain commodities, such as lumber and oil, rose during the first quarter on this feeling of optimism. The U.S. Federal Reserve (Fed) considers this to be good news, and members of the Federal Open Market Committee have repeatedly said that an adjustment process will be necessary. Select price spikes may occur as reopenings create some temporary shortages, but these increases should be short-term and cyclical rather than secular.
We still expect Treasury rates to edge moderately higher throughout 2021, but at a much slower pace.
We believe the secular forces that have been containing long-term inflation for more than a decade are unchanged post pandemic, if not stronger. In addition to the deflationary influence of technology, globalization and aging demographics, the economy remains far from full employment. The unemployment rate has declined to 6%, but millions of people have left the labor force, creating slack that will take time to fully absorb.
The economic rebound of 2021 is being fostered mainly by reopenings and promising vaccination rates. Additionally, the Fed is holding down short-term rates – the consensus view for the first increase is sometime during 2024 – and fiscal stimulus is coming with the American Rescue Plan. Since the $1.9 trillion spending plan (over two years) will not be funded by tax increases, fixed income markets have been wrestling with the $3 trillion deficit over the fiscal year and the resulting increase of U.S. Treasury bond supply.
We believe the recent move from a sub-1% yield was probably the most painful part of the normalization process for fixed income investors, and the 10-year rate now embeds most of what we anticipate for growth, inflation and deficit spending. We still expect Treasury rates to edge moderately higher throughout 2021, but at a much slower pace.
How has this impacted municipal bonds?
The movement in Treasury yields had a meaningful impact on municipal bond prices during the quarter. In general, high-quality, long-duration taxable municipal bonds suffered negative returns as a result of rate volatility. Short-duration and lower-quality taxable municipals generally outperformed.
Higher-quality municipals are more sensitive to the general interest rate environment because they are more highly correlated to U.S. Treasury markets. Credit spread narrowing in lower-quality areas was the best defense against rising rates. For the quarter, AAA-rated municipal bonds returned -3.52% as the highest quality bonds moved in tandem with Treasury yields. At the same time, BBB-rated bonds returned +1.71%.
The BBB area contains more economically sensitive credits that benefited from the same improved sentiment that boosted Treasury markets. This includes issuers that have some social distancing component, such as hotel occupancy bonds, rental car facilities and public transit systems. Additionally, low-quality general obligations or credits downstream from low-quality state and local governments, such as bonds secured by state or local appropriations, outperformed during the quarter.
Credit fundamentals proved resilient, with revenues outperforming expectations and defaults remaining low. Just as full normalization of economic activity appears within reach, municipalities are receiving a large amount of federal government stimulus, further bolstering credit conditions. Against this backdrop of improving fundaments, taxable municipal bonds outperformed U.S. corporate bonds and U.S. Treasury bonds during the quarter.
In summary, tighter spreads and investor demand outpacing supply are helping the municipal bond market relative to other high-quality fixed income.
Taxable municipal supply trend is firmly in place
Taxable municipal bond issuance was $26.9 billion in the first quarter, accounting for 23% of total municipal issuance. This percentage is a few points lower than 2020, when taxable bonds accounted for more than 30%. Second quarter issuance is typically very large, and refunding activity could increase once the U.S. Treasury market stabilizes, potentially creating an environment for further growth in the taxable proportion of total supply.
Longer term, we believe the taxable municipal supply trend is firmly in place. The Fed has signaled that it will remain accommodative for the foreseeable future, which has kept foreign currency hedging costs low. Meanwhile, long-maturity yields have increased more in the U.S. versus many important fixed income markets in Europe and Asia. This has created a buying opportunity for foreign institutional investors who can take advantage of higher yielding municipal bonds relative to global developed nation sovereign debt with zero or negative yields.
In addition, taxable municipals are currently attractive to foreign institutions such as life insurance companies. This is mainly due to the scarcity of high-quality, long-duration fixed income around the globe and the excess spread of investment grade municipals versus equivalently rated corporate bonds.
Further, taxable municipals continue to fill an increasing void in the U.S. corporate bond market. The index experienced $79 billion of A to BBB downgrades in the first quarter and $60 billion falling from AA to A. The corporate market is increasingly comprised of A and BBB-rated bonds.
With this demand backdrop anticipated to remain consistent, municipal issuers will likely continue issuing taxable bonds to diversify their buyer base and access the cost savings opportunities that come from refunding deals.
Infrastructure plan may benefit taxable municipal bonds
President Biden’s recently proposed American Jobs Plan outlines an estimated $2.2 trillion in new infrastructure investment over the next decade. The expansive plan provides funding for traditional infrastructure projects like roads, bridges, public transit, clean water, airports, ports and modernizing school facilities. It also includes significant funding for clean energy, electric vehicles, affordable housing and expanding and high-speed broadband access to rural areas. Funding for veterans’ hospitals, supply chain and manufacturing resiliency and investment in home health care round out the extensive list.
The plan would be paid for by increasing the corporate income tax rate to 28% from the current 21% and implementing several tax law changes for multinational corporations. The spending and tax increases in the American Jobs Plan are part of a larger, Build Back Better initiative.
While we are uncertain what debt structure will finance this infrastructure, we could eventually see authorization of new Build Back Better Bonds, which would be similar to Build America Bonds (BABs), featuring a federal subsidy to offset issuer borrowing costs. This would further accelerate taxable bond issuance.
Infrastructure is a perennial priority in Washington, D.C., but Congress has been unable to enact any meaningful or comprehensive funding in recent years. The Biden administration’s motivation to finally get something done may be extremely high, but it is too early to predict which projects will win out and how much funding will be available from higher taxes.
Municipal spreads have room to narrow
The municipal bond market ended 2020 on a high note, carrying that strength into January. The seasonal trend of light supply and strong demand set the tone for the month against a backdrop of rising Treasury yields, with the Bloomberg Barclays Taxable Municipal Bond Index, a proxy for the market, returning -0.03%. In February, municipal market spread tightening could not fully offset the volatility in U.S. Treasury yields, but the asset class demonstrated relative strength versus U.S. Treasuries and U.S corporate bonds. The index returned -1.94% in February and -1.54% in March, for a first-quarter return of -3.47%.
Since the announcement of effective vaccines in November, credit spreads have tightened. While rapid spread narrowing within the largest and most traded names has compressed index level spreads, dispersion across the market remains. In a tighter index spread environment, individual credit selection through bottom-up research can lead to enhanced yield and outperformance.
The pace of spread tightening since the end of October 2020 has been significant, with the average option-adjusted spread for the Bloomberg Barclays Taxable Municipal Index ending the quarter 61 bps tighter than it was on 31 Oct 2020. However, we believe more tightening is on the way.
The pace of spread tightening since the end of October 2020 has been significant.
In addition to improving fundamentals, the global search for scarce high-quality, long-duration paper continues. Municipal bonds in the AA, A and BBB-rating cohorts still offer wider spreads than U.S. corporate bonds. This option-adjusted spread advantage in municipals is enhanced in lower quality areas, with A-rated taxable municipals at +102 bps vs +71 bps for U.S corporates and BBB-rated taxable municipals at +187 bps vs +112 bps for U.S. corporates.
Taxable municipal supply started the year slowly, then accelerated in late February and March. The total of $26.9 billion was 12% more than the $24.1 billion issued in the first quarter of 2020. This is somewhat misleading, because municipal bond supply was extremely low in March 2020 due to the onset of the pandemic. Nevertheless, strong demand made first quarter 2021 issuance manageable.
Perhaps more interesting than the increase in taxable municipal issuance, is the number of deals issued in the taxable market is up 44%. This reflects the recent trend of smaller deals crossing over to the taxable market, which is a positive development. These smaller, off-benchmark deals offer opportunities to improve diversification and potentially enhance yield.
With low hedging costs for foreign investors, a steeper U.S. Treasury curve and a constructive outlook on municipal credit, demand for taxable municipals appears to be firmly in place. New issue deals have routinely been oversubscribed and any uptick in supply would be welcomed by investors looking toward long-duration, high-quality paper.
U.S. Treasury yields rose, with the 10-year rate leading the way. The spread between 10- and 30-year U.S. Treasuries ended the quarter at 67 bps. Credit spreads for the Bloomberg Barclays Taxable Municipal Index outpaced U.S. corporate bond spread tightening, with taxable municipal bond spreads ending the quarter -31.9 bps tighter than prior quarter-end (80 bps vs 112 bps), while corporate bond spreads tightened just -5.5 bps on average. Municipal spreads continued to tighten as fundamental credit conditions have shown improvement and municipal credit has displayed resiliency. Additionally, passage of the American Rescue Plan Act, which directly and indirectly supports municipal credit, has further improved credit conditions.
Municipal defaults for 2021 totaled roughly $813 million at the end of March, with nursing homes and industrial development revenue bonds representing 74% of all defaults. Defaults have impacted a very small percentage of speculative credits in the overall market. We do not anticipate widespread municipal payment defaults. In fact, given economic performance and the recent passage of stimulus, ratings agencies have improved their outlooks on most municipal sectors from negative to stable.
States and locals get a stimulus boost
The recently enacted $1.9 trillion American Rescue Plan Act will provide the first direct stimulus to state and local governments that is not required to be used specifically for pandemic response efforts. The expected aid is well above projected near-term budget gaps. State and local governments are set to receive $350 billion in direct aid over the next two years. Specifically, states will receive $195 billion and local governments will receive $130 billion, split evenly between cities and counties. Separately, local school districts will see over $120 billion in new federal funding and colleges and universities will benefit as well, with $40 billion earmarked for higher education. Significant funding of $30 billion for transit agencies is also included.
The direct stimulus spending changes the outlook for state and local governments, touching virtually every sector of the municipal market. The American Rescue Plan Act also provides funding for a laundry list of initiatives: enhanced unemployment benefits, direct stimulus payments to individuals, rental and mortgage assistance, funding for vaccinations, expanded tax credits, childcare funding and other measures that will indirectly support tax revenues. This funding mitigates pressure on state and local governments to provide additional support and will fuel tax revenue growth.
Many states did not see budget deficits, and some even saw budget surpluses.
The amount of aid for governments is meaningful, especially in light of how well tax revenues held up over the last year. Though state revenues were projected to decline sharply in 2020, they were only down 2% April through December of that year, compared with 2019. Most states were able to manage budgetary stress without drastic measures. Many did not see budget deficits, and some even saw budget surpluses. Only nine states are expected to see budget gaps of 10% or greater. States most affected by the recession were those dependent on tourism and energy production. Governments that rely on tourism spending were hard hit by reduced travel and social distancing measures. Lower demand for oil and natural gas hurt states dependent on energy tax revenue.
Most states rely heavily on income taxes, and the initial spike in unemployment in early 2020 did not bode well for state revenues. But job losses have been concentrated in low wage sectors like tourism and hospitality, mitigating the net impact on state revenues. High-wage workers were able to transition to work from home and did not see the same rate of losses. Enhanced unemployment benefits have also propped up income tax collections and consumer spending, but states without income taxes like Texas and Florida still saw larger revenue declines. Overall, tax-backed credits have held up very well throughout the pandemic, benefiting from their broad flexibility to respond to revenue fluctuation.
The $195 billion in new federal aid for state governments equals an estimated 16% of own-source, FY19 state revenues. The pandemic-induced downturn is now estimated to produce a net revenue shortfall of only $56 billion for states between fiscal 2020 and 2022, equal to about 6% of FY19 state general fund revenues, making the new funding a major stimulus boost.
Half of the direct stimulus funding for states and locals will be available in the next few months, with the remainder distributed a year from now. State and local governments will have until the end of 2024 to spend stimulus aid, allowing for a more strategic and staggered deployment of funds. Funding cannot be used for pension payments or to fund tax cuts, but it may be used to replace lost revenues, meaning near-term fiscal stress should be deferred for several years for most issuers. If the economic stimulus proves effective, revenues could return to normal quickly.
Positive momentum continues
The municipal market is enjoying many tail winds, particularly in the realm of credit quality. Lower-rated general obligation bonds (GOs) are benefiting enormously from the stimulus, and dedicated tax bonds with revenues tied to tourism-related activity have held up well. Leisure travel is approaching pre-pandemic levels, and airport traffic is returning. Major hospital systems have adjusted to the realities of the virus, and their operations and financials have largely returned to normal.
Given these developments, and the light at the end of the pandemic tunnel, ratings agencies have responded by increasing their outlook to stable for many holdings and sectors. For instance, Illinois bonds have been the top-performing state GO, with downgrade risk postponed for at least several years. Looking forward, an infrastructure package could be another tailwind.
But headwinds do exist. Treasury market volatility has increased and we are still searching for that new equilibrium level. Rate volatility may be the biggest near-term risk to the municipal market. At tighter spreads, taxable municipals have less cushion with which to outperform.
Will the latest round of stimulus combined with a full-blown economic reopening create inflation? Given that most investors are predicting an inflation scare this year, it becomes a bit less scary when inflation eventually ticks up. Rising inflation expectations, combined with a growing federal deficit, creates pressure on Treasuries. But much of this dynamic was priced into fixed income markets in the first quarter. Interestingly, rates started to stabilize at the end of March, just as the yield increase triggered significant demand.
Looking ahead, we believe more winds are blowing positively than negatively for municipal performance.
Gross Domestic Product: U.S. Department of Commerce. Treasury Yields and Ratios: Bloomberg (subscription required). Municipal Bond and Corporate Bond credit spreads: Bloomberg. ICI Fund Flows: http://www.ici.org/research/stats. Municipal Issuance: Seibert Research. Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research. State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report. State Budget Reserves: Pew Charitable Trust. Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD). U.S. Corporate Bond Downgrades: J.P. Morgan. Standard & Poor’s and Investortools: http://www.invtools.com/. Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases.pdf. Payroll Data: Bureau of Labor Statistics. Bond Ratings: Standard & Poor’s, Moody’s, Fitch. New Money Project Financing: The Bond Buyer. State revenues: Bureau of Labor Statistics, National Association of State Budget Officers. Moody’s Analytics, Stress-Testing States: COVID-19-A Year Later February 19, 2021.
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Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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